What is working capital

What is working capital? Quite simply, it's your business's current assets minus its current liabilities. It's a key financial metric that reflects the health and stability of your company. When your working capital is positive, your business has the liquid assets it may need to weather any storm or to support more growth. With a negative working capital, your business most likely has too much debt and may face financial struggles, such as not making rent or payroll.

Working capital isn't one-size-fits-all. How much each company needs will vary from one to another, and your business's size, industry and overall risk profile affect what's considered a "good" amount of working capital.

Working capital vs. cash flow

Cash flow and working capital are both metrics that give you an idea of your business's financial health. Both shine a light on how your company may fare in a rough financial patch. However, they aren't measuring the same thing.

Cash flow shows how much money moves in and out of your business during a defined period. Your company's cash flow can vary throughout the year, particularly if you operate a seasonal business that has a distinct busy period.

Working capital is more static and generally reflects whether your business can pay its bills and obligations, even if you don't have a lot of cash flowing in at the moment.

How to calculate working capital

You can calculate working capital with a simple formula:

working capital = current assets – current liabilities

Current assets include:

• Business inventory
• Cash
• Accounts receivable
• Property owned

Current liabilities include:

• Short-term debt
• Accounts payable
• Payroll
• Taxes owed

Let's say your business has $20,000 in inventory, $5,000 in cash and $10,000 in accounts receivable, or $35,000 in assets. It also has credit card debt of $2,000, $10,000 going out in the next payroll and owes $5,000 in taxes. Its total liabilities are $17,000. If you subtract $17,000 from $35,000, you end up with $18,000 or a positive working capital amount. You can generally cover your debts and have some assets left over just in case the unexpected crops up.

Now, let's flip that and say your business has assets of $17,000 and liabilities of $35,000. When you subtract $35,000 from $17,000, you end up with -$18,000, a negative amount. With negative working capital, your company doesn't have enough to pay its bills and can land in hot water if an unexpected expense comes along.

Why working capital is important

Think of working capital as your business's buffer against the unexpected. When it's positive, your company can afford to pay its bills, its employees and to purchase more inventory. Essentially, the business has what it needs for its day-to-day operations. If you should experience a sudden downturn, your company should still have enough to keep up with its financial obligations.

Having positive working capital also helps your business grow. Investors like to see it because it implies that your company is moving up and that there is a greater likelihood for their investment to grow. If you are looking for financing, having positive working capital signals to lenders that your business has what it will need to repay the debt.

You may also be able to use working capital as leverage when negotiating new contracts with vendors or when trying to get discounts.

What can negatively impact working capital

Too much debt isn't the only factor that can lead to negative working capital. The time of year can also have a negative impact on it. For example, your working capital may take a dip in the lead up to your company's busy season, particularly if you hire more employees. If you give customers a long lead-time to pay their invoices, your working capital may be stretched thin as you wait for people to pay.

Other factors that negatively impact working capital include:

• Inaccurate inventory predictions: Buying too much of a product that doesn't sell can tie up your cash. Similarly, not buying enough of a popular product can also have a negative effect on your capital.
• Rapid growth without funding support: If your business plans to grow, it needs to have funding to back up that growth, otherwise there's the chance of getting in over your head.
• Seasonal sales cycles: After your busy season, you may see a significant decline in sales, which can reduce your assets and lead to a negative or reduced working capital.

How to improve working capital

You can take steps to boost your business's working capital:

• Improve receivables collections: Give customers less time to pay their invoices and be thorough with follow up, sending reminders if customers haven't paid within a week of the due date, on the due date and several days afterward.
• Negotiate better payment terms with vendors: On the flip side, strengthen your business relationships and try to get your vendors to give your company better payment terms. For example, consider asking for a discount if you pay an invoice in advance or try to get a longer payment period, such as net-60 rather than net-30.
• Reduce inventory levels: Too much stock can weigh your company down. Pay attention to how much your business sells and how quickly it sells products to prevent having a warehouse full of items people aren't buying.
• Expense control and budgeting: A budget can do wonders for your company's working capital by helping to keep short-term debt to a minimum and by zeroing in on critical expenses and expenses that could be eliminated.

How financing can strengthen working capital

Although debt financing counts as a liability and may seem as though it would reduce your working capital, there are instances when it can help to bolster working capital. For example, a loan can increase the cash your company has on hand. A business line of credit or credit card can bridge gaps when you may not have the cash available to pay all your bills. Invoice financing, based on the amount of your unpaid invoices, can also help to bridge cash flow gaps when needed.

Citizens can support small business working capital needs

Staying on top of your company's working capital and ensuring it remains positive can help you plan your business's next steps and growth. The right partner can make a difference when it comes to managing working capital. Citizens has small business loans that can meet your working capital needs and help you take your company to the next level. Apply for a small business loan today.

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